Friday, March 19, 2010

Alan Greenspan: The Crisis

This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.

Preamble.

The bankruptcy of Lehman Brothers in September 2008 precipitated what, in
retrospect, is likely to be judged the most virulent global financial crisis ever. To be sure, the contraction in economic activity that followed in its wake has fallen far short of the depression of the 1930s. But the virtual withdrawal, on so global a scale, of private short term credit, the leading edge of financial crisis, is not readily evident in our financial history. The collapse of private counterparty credit surveillance, fine tuned over so many decades, along with the failure of the global regulatory system calls for the thorough review by governments now under way.

The central theme of this paper is that in the years leading up to the current crisis, financial intermediation tried to function on too thin a layer of capital, owing to a misreading of the degree of risk embedded in ever-more complex financial products and markets.

In sections II through V, this paper reviews the causes of the crisis. In sections VI to VIII, the nature of financial intermediation is probed; in sections IX to XV, a set of reforms that I hope address the shortcomings of the existing regulatory structure; in sections XVI and XVII, the role of monetary policy in the current crisis is examined; and section XVIII, the conclusion.

Conclusion

...The global bubble was exacerbated by the heavy securitization of American subprime and Alt-A mortgages that found willing buyers at home and abroad, many encouraged by grossly inflated credit ratings. More than a decade of virtually unrivaled global prosperity, low inflation, and low long-term interest rates reduced global risk aversion to historically unsustainable levels.

The bubble started to unravel in the summer of 2007. But unlike the debt-lite deflation of the earlier dotcom boom, heavy leveraging set off serial defaults, culminating in what is likely to be viewed as the most virulent financial crisis ever. The major failure of both private risk management and official regulation was to significantly misjudge the size of tail risks that were exposed in the aftermath of the Lehman default. Had capital and liquidity provisions to absorb losses been significantly higher going into the crisis, contagious defaults surely would have been far less.

This paper argues accordingly that the primary imperative going forward has to be (1) increased regulatory capital and liquidity requirements on banks and (2) significant increases in collateral requirements for globally traded financial products, irrespective of the financial institutions making the trades. I also note on page 27 a number of less important reform initiatives that may be useful.

But the notion of an effective “systemic regulator” as part of a regulatory reform package is ill-advised. The current sad state of economic forecasting should give governments pause on the issue. Standard models, other than those that are heavily add-factored, could not anticipate the current crisis, let alone its depth. Indeed, models rarely anticipate recessions, unless again, the recession is add-factored into the model structure.

Greg Mankiv's take on how Greenspan proposes to make the financial system more "crash proof":

So what then can we do to make the financial system more crash-proof? Alan offers several good suggestions.

First, and most obviously, we should have higher capital requirements. This is truer now than it has ever been. By bailing out almost every major financial institution that needed it, as well as a few that didn’t, the U.S. federal government has raised the expectations of future bailouts, thereby turning the entire U.S. financial system into, in effect, a group of government-sponsored enterprises. Going forward, creditors to these institutions will view them as too safe, and so they will lend to them too freely. The financial institutions, in turn, will be tempted to respond to their low cost of debt by leveraging to excess. Higher capital requirements are needed to counteract this newly expanded moral hazard.

Second, I like Alan’s idea of “living wills” in which financial intermediaries are required to offer their own plans to wind down in the event that they fail. The advantage to this idea is that when future failures occur, as they surely will, policymakers will have a game plan in hand. How well that will work, however, is hard to say. Like real wills, these financial wills may well be contested by next-of-kin when they are about to be applied. For this plan to work, the living wills had better be widely publicized—say, by putting them on a centralized webpage—to discourage counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do.

Third, and perhaps most important, I like the idea of requiring contingent debt that will turn into equity when some regulator deems that a firm has insufficient capital. Essentially, this debt would become a form of preplanned recapitalization in the event of a future financial crisis. But most importantly, the recapitalization would be done with private rather than public money. Because the financial firm would pay for the cost of these funds, rather than enjoying taxpayer subsidies, it would be incentivized to make itself less risky, for instance, by reducing leverage. The less risky the firm, the less likely the contingency would be triggered, and the lower the interest rate the firm would need to pay on this contingent debt.

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